Europe is to become one of the first regions to introduce new rules on how to safely wind down or restore clearing institutions, which have taken on enhanced roles as shock absorbers in the post-crisis financial system.
Clearing houses, which are also known as central counterparties or CCPs, stand in the middle of a securities trade and ensure it completes even if one side defaults. But the G20-led regulatory drive to push over-the-counter derivatives though clearing has led to concerns CCPs represent possible central failure points that, like banks, might need a substantial government bailout if defaults piled up.
The European Commission has therefore decided to draw up new legislation by the end of 2016 – which it is billing as a framework for the recovery and resolution for CCPs – designed to provide rules for clearing houses faced with significant losses.
Clearing houses’ size and resilience have taken on even greater significance since the prospect emerged of a merger between Deutsche Börse and the London Stock Exchange that would pitch two of Europe’s largest clearers under one roof – Eurex Clearing and LCH.Clearnet.
A leaked draft of the legislation, on which the Commission declined to comment, has been seen by Financial News. Here is what you need to know:
What exactly is CCP recovery and resolution?
The concept is similar to the living will rules drawn up in 2014 for banks and investment firms to enable them to unwind safely without resorting to a taxpayer bailout. But, as clearing houses operate very differently to banks, regulators want them to have their own recovery framework.
Currently, in the case of a major loss, the first port of call is a clearer’s existing resources, including collateral posted by the defaulting firm and that firm’s contribution to the CCP’s wider default fund. Thereafter, contributions are sought from other members, as well as the clearing house’s own resources if need be.
If those resources prove insufficient, the clearing house will then enter into a recovery phase, turning to a range of more drastic measures that may include calling on non-defaulting members for additional capital.
If that fails, the CCP then enters a resolution phase, where critical functions stay open but its other activities are wound down.
What rules do CCPs already adhere to in this area?
European CCPs are directly supervised on a national basis. For instance, UK clearing houses including LCH and ICE Clear Europe, are directly overseen by the Bank of England, which imposes prudential requirements on them as well as certain rules around recovery and resolution.
The 2014 European Market Infrastructure Regulation, or Emir – the EU rule that implements the G20-led clearing mandates – imposed additional capital rules, as well as new governance and oversight responsibilities on CCPs. Emir established a ‘college of regulators’ system to oversee each CCP, led by the national supervisor but including regulators from other countries where it operates as well as the European Securities and Markets Authority.
But harmonised rules do not yet exist across Europe on what to do when CCPs face massive losses or an outright failure. That is what the new legislation aims to address, using global guidelines released in August by the International Organization of Securities Commissions and the Financial Stability Board as a guide.
What specifically is the EU proposing?
The rules propose new ‘resolution authorities’ are set up for each CCP to manage recovery and resolution processes. Mirroring Emir, these authorities would chair a ‘resolution college’ that includes members of a CCPs’ college of regulators under Emir. Resolution authorities may include central banks or other competent authorities.
The rules look set to take the form of a regulation rather than an EU directive, meaning there is no room for national differences. The EU says this is to “best complement and build on the approach established by Emir”, which is also a regulation, and to prevent nationally divergent approaches.
What do the rules say about CCP recovery plans and who is on the hook?
It is proposed that clearing houses should draw up recovery plans to “overcome any form of financial distress which would exceed their existing default management resources”.
Examples given by the Commission of recovery tools include voluntary auctions to allow non-defaulting members to take on positions, variation margin haircutting and requiring members to submit additional resources subject to a cap, something it referred to as a “cash call”. This means clearing members, which are typically large banks, could be called on to stump up funds.
The rules also state that clearing members are required to inform their clients of how they would pass on costs arising from recovery processes, implying that buyside institutions such as pension funds could be called on to provide the necessary emergency funds as well.
The rules also allow authorities to decide whether or not “recovery plans should cover parent companies” of CCPs. In the case of LCH, for example, that would mean its owner the LSE could be on the hook for cash calls.
The Commission’s draft rules look to have taken note of clearers’ calls for flexibility, stating specifically that “CCPs can determine the appropriate range of options and recovery tools”.
While these plans should not rely on “extraordinary public finance assistance” they should include plans for “possible access to central bank facilities under standard terms”.
What do the rules say about resolution plans?
Resolution plans will also need to be drawn up outlining how CCPs should be restructured and their critical functions kept alive in the event of a failure. The rules specifically state that resolution authorities should have the power to change a CCP’s business activities, or its operational or legal structure, in such situations.
Potential tools include selling a CCP’s critical functions to a competitor, the creation of a publicly controlled “bridge CCP”, as well as allocating losses among clearing members. If non-defaulting members contribute a cash contribution to a CCP, they would be required to take an equity stake in that CCP, according to the draft rules.
But again flexibility is allowed in this area: “The regulation does not mandate which tools and powers to use in different scenarios but leaves the choice to the authority.”
What is the last resort – can the government be called upon if a CCP is failing?
If all other means are exhausted the rules propose that temporary government ownership of a CCP could be considered as a “last resort” – provided it complies with EU rules on state aid.
Such a step would require a restructuring of the CCP and the ability to “enable the deployed funds to be recouped from the CCP over time”, according to the document.